Does macroeconomic uncertainty increase or decrease aggregate growth and asset prices? To address this question, we decompose aggregate uncertainty into `good' and `bad' volatility components, associated with positive and negative innovations to macroeconomic growth. We document that in line with our theoretical framework, these two uncertainties have opposite impact on aggregate growth and asset prices. Good uncertainty predicts an increase in future economic activity, such as consumption, output, and investment, and is positively related to valuation ratios, while bad uncertainty forecasts a decline ineconomic growth and depresses asset prices. Further, the market price of risk and equity beta of good uncertainty are positive, while negative for bad uncertainty. Hence, both uncertainty risks contribute positively to risk premia, and help explain the cross-section of expected returns beyond cash flow risk.

Uncertainty plays a key role in economics, finance, and decision sciences. Financial markets, in particular derivative markets, provide fertile ground for understanding how perceptions of economic uncertainty and cashflow risk manifest themselves in asset prices. We demonstrate that the variance premium, defined as the difference between the squared VIX index and expected realized variance, captures attitudes toward uncertainty. We show conditions under which the variance premium displays significant time variation and return predictability. A calibrated, generalized Long-Run Risks model generates a variance premium with time variation and return predictability that is consistent with the data, while simultaneously matching the levels and volatilities of the market return and risk free rate. Our evidence indicates an important role for transient non-Gaussian shocks to fundamentals that affect agents' views of economic uncertainty and prices.

In their seminal paper, Mehra and Prescott (1985), Rajnish Mehra and Edward Prescott were the first among many subsequent authors to suggest that non-traded labor-market risk may provide a resolution to the equity-premium puzzle. The most direct demonstration of this was Constantinides and Duffie (1996), who showed that, under certain conditions, cross-sectionally uncorrelated unit-root shocks which become more volatile during economic contractions can resolve the puzzle. We examine the robustness of this to life-cycle effects. Retired people, for instance, do not face labor-market risk. If we incorporate them, to what extent will the equity premium be resurrected? Our answer is “not very much." Our model, with realistic life cycle features, can still account for about 75% of the average equity premium and the Sharpe ratio observed on the U.S. stock market.

What is the effect of non-tradeable idiosyncratic risk on asset-market risk premiums? Constantinides and Duffie (1996) and Mankiw (1986) have shown that risk premiums will increase if the idiosyncratic shocks become more volatile during economic contractions. We add two important ingredients to this relationship: (i) the life cycle, and (ii) capital accumulation. We show that in a realistically calibrated life-cycle economy with production these ingredients mitigate the ability of idiosyncratic risk to account for the observed Sharpe ratio on U.S. equity. While the Constantinides-Duffie model can account for the U.S. value of 41% with a risk-aversion coefficient of 8, our model generates a Sharpe ratio of 33%, which is roughly half-way to the complete-markets value of 25%. Almost all of this reduction is due to capital accumulation. Life-cycle effects are important in our model — we demonstrate that idiosyncratic risk matters for asset pricing because it inhibits the intergenerational sharing of aggregate risk — but their
net effect on the Sharpe ratio is small.

We use a production-based asset pricing model to investigate whether financing constraints are quantitatively important for the cross-section of returns. Specifically, we use GMM to explore the stochastic Euler equation imposed on returns by optimal investment. Our methods can identify the impact of financial frictions on the stochastic discount factor with cyclical variations in cost of external funds. We find that financing frictions provide a common factor that improves the pricing of cross-sectional returns. Moreover, the shadow cost of external funds exhibits strong procyclical variation, so that financial frictions are more important in relatively good economic conditions.

This paper asks whether the asset pricing fluctuations induced by the presence of costly external finance are empirically plausible. To accomplish this, we incorporate costly external finance into a dynamic stochastic general equilibrium model and explore its implications for the properties of the returns on key financial assets, such as stocks, bonds and risky loans. We find that the mean and volatility of the equity premium, although small, are significantly higher than those in comparable adjustment cost models. However, we also show that these results require a procyclical financing premium, a property that seems at odds with the data.